China is the problem, not Greece

Some forecast that Greece and the euro could part company this weekend. But whether it goes or it stays with another solution to the problem, however short-lived, the world of Athens may prove to be a sideshow. Greece is, after all, a very small part of the eurozone.

It could spread, of course. There is the well-voiced fear of "Greek contagion" – its problems spread to Portugal, Spain, Italy and perhaps France leading to the break-up of the zone.

But investors could be looking at the wrong country, even the wrong continent, in their search for the nation that could destabilise the financial world.

For that dubious honour, step forward the nation that is widely feted as the saviour of global capitalism and the future economic powerhouse of the world. It's the nation whose mere mention causes fund managers to salivate, investors to swoon and politicians to suck up to its leaders. And that country is China. As demand from Europe and North America dries up, it has the potential to undo the very system that it has propped up with its cheap labour exports, undervalued currency, and willingness to buy all sorts of government and corporate bonds.

Chinese shares show nervousness

The Shanghai stock market seems to have run out of steam. Last July it stood at over 2,800. Now it is more than 400 points lower at 2,373 – a 16 per cent fall. Obviously, not every stock or every fund has fallen that far – it's an average so some will have shed more, others less or even gained. This can be largely attributed to factors such as the index had moved too far and too fast in too short a space of time – profit taking – and to known problems such as corruption, unreported strikes and civil unrest, and to the still new phenomenon of "reshoring" – taking work back to the United States or Europe because it is more profitable, taking advantage of lower labour costs and shorter supply lines.

As a pause for breath, it is readily explained. But could it be more? What if the well-rehearsed narrative of an increasingly well-off Chinese middle class ready to consume goes into reverse? And what if a resulting Chinese bear market leads to instablity capable of affecting world markets?

If any of this happens, then Greece, with a population smaller than Beijing will be exposed as a mere distraction. A Chinese problem, let alone a crisis, could bring the world financial order to its knees.

This is not the apocalypse economics of a wild fringe. Stephen S. Roach, author of The Next Asia, one time Chairman of Morgan Stanley Asia and the firm's Chief Economist, and now a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management is worried.

He writes that Asia largely escaped any backlash from the 2008-09 banking crisis. While growth in China and elsewhere in Asia slowed, the region pulled through an "extraordinarily tough period in excellent shape."

That was then and now is now

But Roach says: "That was then. For the second time in less than four years, Asia is being hit with a major external demand shock. This time it is from Europe, where a raging sovereign-debt crisis threatens to turn a mild recession into something far worse: a possible Greek exit from the euro, which could trigger contagion across the eurozone. This is a big deal for Asia."

The Chinese tiger is vulnerable in its eurozone tail. Asia would suffer from a European banking crisis, especially one which proves contagious. Asia is more dependent on western bank credit than its rulers and fan base care to consider. So while Europe might be able to deal with Greece and prevent contagion, can it ensure that problems are not exported to China?

China bulls are heartened by what seems to be the shrinking importance of Europe and the United States in the trade balance. But many of the figures, Roach argues, are boosted by trade between Asian countries in semi-finished goods.

Around two thirds of all trade flows in the region can be classified as "intermediate goods" – components that are made in countries like Korea and Taiwan, assembled in China, and ultimately shipped out as finished goods to the West.

Expansion betting heavily on Western demand

China's economy is substantially reliant on the west so it cannot escape demand falls in developed countries. It has bet heavily that its economic growth is predicated on European demand – withdraw that and China has to find another engine. This is coupled with a slowdown in domestic growth, possibly as the easy pickings have gone, leaving the harder work behind.

Roach calculates that the annual export gain has slowed from 20% in 2011 to 5% in April 2012. This is significant but not a disaster, unless coupled with a disorderly euro breakup. Then Chinese companies, many with opaque balance sheets or dependent on corrupt accounting practices, could start to default on their loans from European banks.

As early as last August, there were warnings of Chinese fragility – just as many were forecasting the Chinese currency would eventually replace the US dollar as the engine of world trade.

And, more recently, weakening global commodity prices are an additional warning that the Chinese story is running out of steam.

The hope must be that China can create a firewall to protect its economy from worst the eurozone crisis can throw at it. But to do that, it needs to build up alternative markets.

Roach says: "The recently enacted 12th Five-Year Plan (2011-15) has all the right ingredients to produce the ultimate buffer between the dynamism of the East and the perils of a crisis-battered West. But, as the euro crisis causes China
9;s economy to slow for the second time in three and a half years, there can be little doubt that implementation of the Plan's pro-consumption rebalancing is lagging."

The vicious circle scenario

China has been exporting its trade surpluses – often in the shape of buying government bonds in the west. If its trade surplus declines, it will withdraw some or all of its purchasing power, leading to a rise in bond yields. The scenario could then go higher interest rates, lower consumer demand, a fall-off in Chinese production, civil unrest as the Chinese Communist Party fails to fulfil expectations and Chinese banking defaults.

The west, which has become as addicted to the China growth story as it had been to credit-driven sub-prime property plays, will then be caught in a vicious circle that could dwarf anything from Athens or even the rest of peripheral Europe.

Ending on a positive note

Or maybe it could be business as usual. The Chinese could extricate themselves from the mess and prove to be the world's financial saviour, not a threat many times greater than Greece.

The narrative of the amazing speed and depth in China's economic transformation over the past 30 years and its creation as the world's manufacturing engine room may work through.

It may create its own banking system to ensure its growth continues. But the warning signs are there. Fast growing consumer demand fuelled by domestic credit institutions, dependent on foreign banks for funding, has the inherent seeds of instability that could bring down the world economic system, leading to trade barriers and the end of this round of Chinese expansion.

However, China with its rigid state control could show the world how to escape the tyranny of the free market model. If that happens, then the current economic system in the west will come up renewed socio-political pressure.